Dirt-for-debt plans occur in real estate bankruptcy cases when a developer has several tracts of land that are secured by first-lien and sometimes second-lien financing. Dirt-for-debt plans propose to convey all or a part of the collateral (or sometimes, substitute collateral) to a lender in full satisfaction of its debt; hence the phrase “dirt-for-debt.”
These plans were commonplace in 1980s, when the Texas real estate market was in a severe decline. Recently, dirt-for-debt plans have reemerged in Texas and elsewhere because commercial real estate prices have dropped significantly and sources of real estate financing remain scant.
U.S. Bankruptcy Code Section 1129(b)(2)(A) requires that, to be considered “fair and equitable” in a nonconsensual case, a plan must provide that a secured creditor will (i) retain all liens securing the claims and receive deferred cash payments equal to the allowed amount of the claim under the plan, with a present value of the creditor’s interest in the collateral, (ii) be paid from the proceeds of any sale of its collateral, or (iii) receive the “indubitable equivalent” of its claim. Dirt-for-debt plans are predicated on the premise that conveying the secured creditor’s collateral back to the secured lender in satisfaction of its claim satisfies the “indubitable equivalent” requirement.
Congress added Section 1129(b)(2)(A)(iii) to the Bankruptcy Code in 1978. See 124 Cong. Rec 32407 (1978). The 5th U.S. Circuit recently explained:
Congress did not adopt indubitable equivalent as a capacious but empty semantic vessel. Quite the contrary, these examples focus on what is really at stake in secured credit: repayment of principal and the time value of money. Clauses (i) and (ii) explicitly protect repayment to the extent of the secured creditors’ collateral value and the time value compensating for the risk and delay of repayment. Indubitable equivalent is therefore no less demanding a standard than its companions. Bank of New York Trust Co., N.A. v. Official Unsecured Creditors’ Committee (In re The Pacific Lumber Co.), 589 F.3d 229, 246 (5th Cir. 2009).
The term “indubitable equivalent” emerged from Judge Learned Hand’s decision in In re Murel Holding Corp., 75 F.2d 941 (2d 1935). In that case, the Bankruptcy Court denied confirmation of a plan that would have extended the time of payment to a first mortgage holder and would also have given lien priority to a lender of new money. The plan proposed to pay the secured creditor interest on the collateral (an apartment building) for 10 years, with full payment of the principal at the end of that time, but without making any provisions for amortization of principal or for maintenance of the collateral over the 10-year term. There, the 2d U.S. Circuit Court of Appeals stated:
It is plain that adequate protection must be completely compensatory; and that payment ten years hence is not generally the equivalent of payment now. Interest is indeed the common measure of the difference, but a creditor who fears the safety of his principal will scarcely be content with that; he wishes to get his money or at least the property. We see no reason to suppose that the statute was intended to deprive him of that in the interest of junior holders, unless by a substitute of the most indubitable equivalence. 75 F.2d at 942 (emphasis added).
Hence, the court refused to confirm the “wholly speculative” plan because it provided that the creditor would receive neither money nor property, nor would he receive an equivalent substitute. Id.
Gauging Indubitable Equivalence
It is clear that transferring all of the lender’s collateral back to it satisfies the indubitable equivalent requirement. See 124 Cong. Rec. 32407 (1978) (“Abandonment of the collateral to the creditor would clearly satisfy indubitable equivalence . . .”); Pennave Properties Assocs, 165 B.R. 793 (E.D. Pa. 1994).
However, courts considering dirt-for-debt plans have recognized that, when a plan proposes to alter or transfer less than all of a secured creditor’s bargained-for real property collateral, the “indubitable equivalent” standard of Section 1129(b)(2)(A) requires “stringent standards of equivalence” and substitute collateral values that “far exceed” the amount of the debt to be paid to ensure that the creditor’s risk exposure is not increased, especially in unstable markets.
Courts have interpreted Hand’s discourse in Muriel Holdings regarding indubitable equivalence as being comprised of two components. First, the indubitable equivalent of a secured claim exists if the substituted treatment of the creditor is “completely compensatory,” such that the secured creditor will receive the full value its claim. Second, when a plan proposes to transfer property to the secured creditor in satisfaction of its claim, the court will look to the likelihood that the creditor will be paid, such that a secured creditor will receive the indubitable equivalent of its claim only if the substituted property does not increase the creditor’s risk exposure.
In attempting to place a value on the real property that is to be transferred to a creditor in satisfaction of debt, courts have consistently recognized that a conservative approach is appropriate. See, e.g., In re Simons, 113 B.R. 942, 947 (Bankr. W.D. Tex. 1990). In In re Simons, the court articulated three reasons for a conservative valuation of such property:
- The burden of sale is shifted from the debtor to the secured creditor, including the risk of loss inherent in a depressed market and with respect to the type and location of the real property.
- Because the creditor will not be paid interest for the time it must hold the property before it is sold, the creditor is effectively getting a “partial payment in kind that must be turned into cash prior to receiving a return.”
- Valuation is not an exact science, and the chance for error always exists. 113 B.R. at 947.
Bankruptcy courts use the valuation process—including the adjustment of appraisal values—to compensate the secured creditor for existing or potential market instability. Shifting the burden of sale and risk of loss to the secured creditor will rarely be considered to be the “indubitable equivalent” when the creditor is not adequately compensated for such risk.
In Sandy Ridge Development Corp. v. Louisiana National Bank (In re Sandy Ridge Development Corp.), 881 F.2d 1346 (5th Cir. 1989), the debtor filed a plan that proposed to convey one piece of property (Brightside) to the senior secured creditor that held a first-priority lien on the property, plus up to $100,000 worth of another piece of property upon which the creditor held a second lien, in full satisfaction of the debt. The Bankruptcy Court refused to confirm the plan because, among other things, it found that the plan did not satisfy the requirements of Section 1129(b)(2)(A)(iii).
The 5th U.S. Circuit Court of Appeals reversed and remanded, explaining:
Since the value of LNB’s secured claim is equal to the value of Brightside, a plan which provides that LNB will realize the indubitable equivalent of Brightside will satisfy the requirements of section 1129(b)(2)(A)(iii). The current plan provides that LNB will receive Brightside itself, and since common sense tells us that property is the indubitable equivalent of itself, this portion of the current plan satisfies the "indubitable equivalent" requirement.Id. at 1350.
The 5th Circuit held that “the transfer on plan approval of all its collateral to a secured creditor, at a value properly fixed by the bankruptcy court, gives that creditor the indubitable equivalent of its secured claim.” Id. at 1354.
In Brite v. Sun Country Development, Inc. (In re Sun Country Development, Inc.), 764 F.2d 406, 408 (5th Cir. 1985), the debtor filed a plan that proposed that the lender’s first-priority lien on 200 acres would be released in exchange for 21 specified notes secured by 21 separate lots. The lender objected to the plan and contended, among other things, that the 21 notes from 21 obligors secured by 21 separate lots was not the indubitable equivalent of its first lien on 200 acres. Id. at 409.
However, the debtor presented evidence to the Bankruptcy Court that the present value of the notes was over $200 more than the outstanding debt and that the value of the lots securing the notes was about $130,000 more than the outstanding debt. Id. The 5th Circuit explained:
To the extent that Brite attacks the findings of the bankruptcy court, we reject his complaints, as the findings were supported by the evidence. We further believe that Brite’s other concerns do not render the twenty-one notes dubitable equivalent of the original first lien. As reflected by the district court record, since Brite has taken over collection of the notes, the debtors have generally kept their payments on notes current. Furthermore, if debtors do default on their notes, the value of the land securing the notes, as found by the bankruptcy court, appears sufficient to cover the additional expense of foreclosing on twenty-one separate properties.Id.
Sun Country is probably an anomaly because most courts have disfavored allowing a debtor to substitute a lender’s collateral. Additionally, in Pacific Lumber, 589 F.3d 229, 246 (5th Cir. 2009), the 5th Circuit upheld a debtor’s plan that cashed out a secured lender at the Bankruptcy Court’s finding of value, without permitting the secured lender to credit bid at the proposed sale. The Pacific Lumber court held that the cash payment of the court-determined valuation was the “indubitable equivalent” of the secured lender’s claim. Id. at 245-249.
In the recent case of In re LBJ Lakefront, Inc., No. 10-10023-CAG (W.D. Texas 2010), the debtor filed a plan in which it proposed to satisfy the lender’s secured claim by conveying less than all of the lender’s collateral to it in full satisfaction of its claim. The proposed treatment of the lender’s claim was predicated on the premise that, based on the valuations by the debtor’s experts, the value of the portion of the collateral proposed to be conveyed to the lender equaled the amount of the outstanding indebtedness and that therefore such transfer fairly compensated the lender on account of its claim.
The lender objected to confirmation of the plan on grounds that it did not provide the lender with the indubitable equivalent of its claim under Section 1129(b)(2)(A)(iii) and was therefore not confirmable. The debtor contended that the plan sought the treatment of the lender’s claim by ostensibly providing the indubitable equivalent of such claim.
The Bankruptcy Court, following In re Simmons, denied confirmation of the plan after finding that the debtor’s valuation of the property was inflated and that the plan was not filed in good faith since, as the court explained, the debtor “was afforded ample opportunity to liquidate the property to satisfy the bank’s claim . . . . And as a result, held off the bank for what I thought was an unreasonable amount of time when the debtor had the ability to pay off the claim.” (Transcript, pp. 29-30). The debtor filed a notice of appeal, which remained pending when this article was written.
What is clear is that dirt-for-debt plans are back. It is important for real estate debtors to know and understand their options with respect to their ability to surrender or possibly substitute real property collateral to secured creditors in full or partial satisfaction of their claims. Likewise, it is important that creditors with real estate collateral know their rights and pay close attention to the proposed treatment of their claims in bankruptcy to protect their rights.
 See In re Martindale, 125 B.R. 32, 38-39 (Bankr. D. Idaho 1991) (stating that “in an uncertain market it is doubtful that such a plan offers the creditor the indubitable equivalent of its claim unless the appraised value of the property far exceeds the amount of debt to be paid.”); see also In re Walat Farms, Inc., 70 B.R. 330, 334 (Bankr. E.D. Mich. 1987) (denying confirmation where “no matter how hot the market for real estate may become in the future, the market for farm real estate here and now is not such which would permit us to hold that the value of the land being offered is the indubitable equivalent of Equitable’s claim”).
 B.M. Brite v. Sun Country Dev., Inc. (In re Sun Country Dev., Inc.), 764 F.2d 406, 409 (5th Cir. 1985); Metropolitan Life Ins. Co. v. San Felipe @ Voss, Ltd. (In re San Felipe @ Voss, Ltd.), 115 B.R. 526, 529 (S.D. Tex. 1990)
 In re B.W. Alpha, Inc., 89 B.R. 592, 596 (Bankr. N.D. Tex. 1988) (stating that the indubitable equivalent standard requires substituted collateral that “produces a cash flow or is capable of being sold within a reasonable time so that the creditor can realize cash.”); see also Brite v. Sun Country Dev., Inc. (In re Sun Country Dev., Inc.), 764 F.2d 406, 409 (5th Cir. 1985); In re San Felipe @ Voss, Ltd., 115 B.R. at 529 (“In a particular case, a bankruptcy court should look to the stability and liquidity of the proffered [property].”); see also Arnold & Baker Farms v. U.S. (In re Arnold & Baker Farms), 85 F.3d 1415, 1422 (9th Cir. 1996) (affirming reversal of bankruptcy court’s order confirming a plan where the secured creditor would be “forced to assume the risk of receiving less on the sale without being able to look to the remaining undistributed collateral for security.”); F.H. Partners, L.P. v. Inv. Co. of the Southwest, Inc. (In re Investment Co.), 341 B.R. 298, 319 (10th Cir. B.A.P. 2006) (“Where collateral is to be substituted, two attributes of the substituted collateral – its value and the degree of risk that it imposes on the secured creditor – determine whether the new collateral is sufficiently ‘safe’ and ‘completely compensatory.’”).
 See In re San Felipe @ Voss, Ltd., 115 B.R. at 530-31 (affirming a bankruptcy court’s finding that nearly one-third over the amount of the allowed claim was adequate to guard against depreciation where the securities to be transferred had remained stable in value for the previous two years); In re Atlanta Southern Business Park, Ltd., 173 B.R. 444, 451 (Bankr. N.D. Ga. 1994) (noting the court’s conservative valuation and downward adjustment of appraisal values “in view of the inherent risks [the bank] will face if it is forced to accept the property in complete satisfaction of its claim.”).
 See, e.g., In re B.W. Alpha, Inc., 89 B.R. at 596 (denying confirmation when the debtor proposed to convey property that it had previously been unable to sell and stating that “[g]iving the Bank a partially remodeled building, which the Debtor has been unable to sell for two years, certainly cannot be said to be the indubitable equivalent of the Bank’s claim.”). See, e.g., In re Monnier Bros., 755 F.2d 1336, 12 C.B.C.2d 323 (8th Cir. 1985); F.H. Partners, L.P. v. Investment Co. of the Southwest, Inc. (In re Investment Co. of the Southwest, Inc.), 341 B.R. 298 (B.A.P. 10th Cir. 2006); Sunflower Racing, Inc. v. Mid-Continent Racing & Gaming Co. (In re Sunflower Racing, Inc.), 226 B.R. 673, 687 (D. Kan. 1998) (promise to provide letter of credit for plan obligation to pay secured claim on “Implementation Date,” which could be up to two years after confirmation, not indubitable equivalent, since the terms of the letter of credit were not stated, and the creditworthiness of the applicant for the letter of credit could worsen during two-year period).
 Fulbright & Jaworski L.L.P. represents the secured lender in this case.
 Courts interpreting Section 1129(a)(3) have recognized that the good faith inquiry focuses on examining the “totality of the circumstances” surrounding the proposed plan and whether there is a reasonable likelihood that the plan will achieve results consistent with the standards under Section 1129. See Sun Country, 764 F.2d at 408; Public Fin. Corp. v. Freeman, 712 F.2d 219, 221 (5th Cir. 1983); In re Save Our Springs (S.O.S.) Alliance, Inc., 388 B.R. 202, 247 (Bankr. W.D. Tex. 2008); In re Ferch, 333 B.R. 781, 784 (Bankr. W.D. Tex. 2005).